It’s rare that I am completely or mostly ‘out of the market’ but this is one of those times. I tend to travel a lot in the summer and when the market cooperates I like to take profits and leave the city with small to no positions on to worry about. On vacation I like to log on to Thinkorswim no more than once or twice a day. With the recent downturn in the markets I have done very well and took off lots of profits…

However, going into the Independence day holiday vacation for a week, I can’t resist having some short delta trade on. I really think we are going to give back a few more months of gains from the previous year long rally. As my friends and readers know I never believed in the rally from March 2009.

So, I want a low maintenance trade that I can look at once or twice a day on vacation that requires little to no work. I would have liked it to be Theta positive but it starts off short Theta.

Trade logic:

I want to be short delta but have protection to the upside.

I want to be long Vega but not get hurt too badly if the market goes up and IV drops.

I want to have a limited risk trade.

I like trading the OEX. I get good fills, often better than theoretical prices. It has good liquidity with 100’s to 1000’s of contracts of open interest. It requires 1/10th as many contracts as SPY (hence 1/10th the commission, sorry Tom Sosnoff).

Here’s the trade:

First I put on an Aug / Sep $425 / $470 put diagonal. (+10 Sep $470 puts / –10 Aug $425 puts). This gets me long Vega and short Delta with a small positive Theta. It has limited losses to the upside but is sensitive to a drop in IV. It looks like this: (Click any picture to enlarge)

Next, I put on an Aug / Sep $475 / $480 ratio call reverse diagonal. (+10 Aug $475 calls / –5 Sep $480 calls). This gets me long delta and long Vega and is short Theta. Being long vega is a double edge sword here. If the market moves in the desired direction, down, the long Vega will make this hedge lose less, but it also makes it a less hedge than it first appears. However, it is very long delta so that lessens the long Vega losses on the upside. On the downside it has limited losses and becomes more of a long vega play than long delta. This part of the trade looks like this:

The combined trade looks like this:

I like to use diagonal spreads more than calendars. I often find that I’ll put on an OTM put calendar and I’m correct and the underlying moves down very quickly. When a calendar moves too quickly you don’t make anywhere near maximum profit. For a calendar to make (near) max profit the underlying needs to be at the short strike at expiration week, not right away. With the diagonal spread there isn’t that change in delta after you cross past the short strike price.

I also like the above ‘ratio call reverse diagonal’. It’s positive delta outweighs the long vega on the way up and as time goes on, it becomes less long vega and if the underlying moves down the long vega offsets some of the short delta.

Exit strategy: Obviously I would not hold this trade past the Aug expiration despite owning Sep options. I’ll look to take profit or small losses if the underlying moves up quickly. I’ll also take small losses if it stays in a tight range and suffer from the short theta. If if moves down past $450, I’ll start taking off one or a few contracts at at time to lock in some profit but I will not be in a rush to do so b/c I’ll be long theta at that time and presumably benefitting from my long vega.

Have a nice Independence day, and hopefully enjoy your long holiday theta!

Instead of my usual commentary on the Volatility of an individual equity, I’m going to make a few statements about market Volatility today.

Below is the LiveVol Software chart of the VIX year to date. (Click any picture to enlarge) You can clearly see the run up since 4/27/10 has continued today. Below the VIX chart is the year to date chart of the SPX. Interestingly, the SPX correction in Jan – Feb was more severe than the recent correction yet VIX is moving more on this correction. Below the VIX candle chart is the Implied Volatility of the VIX, or the volatility of the volatility. It is clearly higher than back in Jan – Feb.

I was thinking of why the VIX was so much more active in this correction vs. the last one. I came up with a few ideas and I’d love to hear your feedback on this subject…

Leading up to this correction we’ve had a much steeper and longer run up from the recent 2/5/10 bottom.

Longs had given up on buying index puts for protection that lost month after month and are now scrambling to buy them.

I read a rumor on StockTwits that someone had a very large short VIX futures position that is getting a big short squeeze.

According to my inside sources, many retail customers were very short naked puts, ETF, Index and Equity. This would cause a panic short squeeze to cover the naked puts. These puts would have been sold in Mar and Apr when VIX was bottoming. Selling naked puts at the VIX bottom is a dangerous thing.

Personally, I’m dealing with this VIX run up as I’m short (bearish off-center) strangles in SPY and OEX which is hurting. Luckily I bought some cheap OOM puts that are doing quite well offsetting my very short Vega. Additionally, when VIX was bottoming I bought some RUT back spreads that I’ve adjusted to be delta neutral and very long Vega which is working well.

Mark Sebastian at www.option911.com often talks about buying these OTM puts called “units”. He also talks about hidden delta which in this case is short delta these OTM puts acquire as the market drops and Vega increases. (Mark correct me if I’ve misquoted you.) I highly recommend reading Mark’s blog posts on this subject.

Note: If you are unfamiliar with the Thinkorswim platform, usually when I post analyze tab screenshots, the lighter color blue is the one standard deviation move in the underlying by expiration of the front month options in the position.

So, now I’m thinking of adjusting this trade. I can take off the whole thing for a quick profit or modify it. I’m thinking the market has more to decline and thus higher VIX. So, I want to reduce my risk and exposure to the opposite happening, i.e. reduce my short delta, and reduce my long Vega. How is the hard question. There are many ways to do this…

Positive delta, and negative Vega. If you thought short put that would be right. I also considered selling an OTM call straddle. Both of these give me long theta. I’m going to choose the short puts to keep it a little more simple.

The higher the strike put, the more short delta I get. I chose to sell 5 contracts of the Jun 120 put.

This changes my short delta from –1067 to –761, still very short. My Vega changes from 128 to 48. This way if the market rallies and the IV collapse from today’s spike peak, it won’t hurt as much. The new analyze tab looks very similar to the above.

Still short delta and long vega.

Below in the LiveVol Pro software, 6 month chart of IV, you can see the front month and back month IV of SPY continues to climb with today’s selloff. It has not been this high since the major selloff in January.

As you can see from the 5 minute chart below, AUXL dipped down in the premarket to $34.50 and is currently trading at $35.63, down $0.03.

I am watching the chart of Implied Volatility in LiveVol Pro software, pictured below. I can see right before my eyes the IV dropping and concurrently seeing increasing profit in my Thinkorswim platform. The horizontal line is the IV on Friday around 45%, and just above 43% this AM.

End of day Friday we were at a $500 loss. As of right now we’re up $812.50 for a total of up $312.50. The conference call is scheduled to start in less than 10 minutes. The conference call may move the underlying which is currently not moving much, but it may also remove more unknown and be another ‘Vol Event’ and help our trade.

Friday morning we sold an Iron Condor on AUXL in anticipation of their earnings release this morning (Monday) before market open. As of 7:43 AM Monday morning the underlying has not traded any shares pre-market. Reuters is reporting, “Q1 loss narrower than expected” at loss of $0.18 vs. an estimated loss of $0.32.

When you’re short an iron condor ‘no news is good news’. The fact that no shares have traded premarket is a good sign to me but we’ll wait for the open to count our [drop in IV] money.

Here’s an interesting note on this trade: Friday I checked the status of this trade between surgeries. (Yes, I look at the market between surgery patients. No, it doesn’t affect the surgeries.) Mid day this trade was losing over $1,300 because IV went up significantly. We entered the trade for a credit of $1.05 per spread. On Friday, I tried to sell an additional 25 contract spread for then current mid-price of $1.60. That would have increased my credit to an average price of $1.325 per spread but it never executed. Oh well, that’s part of the price for using a less liquid underlying. At the close the spread was trading $1.25 at the mid-price (-$500).